CAPITAL AND REVENUE

EXPENDITURES AND

RECEIPTS

Importance of Distinguishing between Capital &

Revenue Items

• TO DETERMINE WHICH ITEMS APPEAR IN WHICH FINANCIAL STATEMENT.

Revenue items - profit and loss account

Capital items - balance sheet

• DETERMINATION OF THE NET PROFIT

Requires Matching of revenue expenditure and revenue income (As per Matching Concept)

PROFITS =

REVENUE RECEIPTS – REVENUE EXPENSES

Capital and Revenue Receipts • Capital Receipts comprise of

• Contributions of capital into the business by the proprietor, partners or shareholders

• any sums received from debenture holders,

• any loans and

• Sale proceeds of any fixed assets & long term

investments.

• Revenue Receipts or income

– are the outcome of firm’s activity in the accounting period;

– money received on sale of goods in trade or on rendering of services.

• Examples: Sales, commission and fees received, interest /dividend on investments

Distinction Between Capital and Revenue Receipts

Capital Receipts Revenue Receipts

Includes amounts realized by

sale of fixed assets or by

issue of share or debentures.

Includes amount realized

by sale of goods or

rendering services

It is a receipt in substitution

of a source of income

It is a receipt in substitution

of an income.

Amount received for

surrender of certain rights

under an agreement is a

capital receipt, because a

capital asset is being given

up in the form of these rights

Amount received as

compensation under an

agreement for the loss of

future receipts is a revenue

receipt

Classification of income

• Capital income

• Revenue income

Capital Profits / Capital Income

• Capital income is an income which does not relate to

operations of the business or which does not grow out

of or pertain to the running of the business proper.

Capital profits are profits earned on account of sale

of fixed assets or in connection with share capital

Capital Profits / Capital Income

• Examples:

Share premium,

sale of a fixed asset for a value more than that for

which it was purchased.eg. Capital gain of Rs 150,000

arises when building bought for Rs. 200,000 is sold

for Rs. 350,000.

• Note: Only the profit realised over and above the cost of the fixed

asset should be taken as capital profit (transferred to capital reserve)

while the profit realised over and above book value of the asset till it

does not exceed the original cost of the asset should be taken as

revenue profit (credited to Profit and Loss Account)

Revenue Profits / Revenue income

• Revenue income is an income which arises out of and in

the course of regular operations of the business concern

• Revenue profits appear in the Profit and Loss Account

• Revenue profit and revenue income are synonymous.

Revenue profits are those earned in the ordinary

course of business

Examples:

Profit made on sale of goods, income received from letting out of the

business property, dividends received on business investments, etc.

Expenditure

Expenditure refers to a payment or spending or a

promise to make future payment for benefits

received i.e. for assets or services.

Classification of Expenditure

• Capital Expenditure

• Revenue Expenditure

• Deferred Revenue Expenditure

Capital Expenditure

Such expenditure is either incurred for

• acquisition of a fixed asset (tangible or intangible) or

• permanent improvement or addition or substitution

or extension to an asset to increase the earning

capacity of the business enterprise

Capital Expenditure is any expenditure which is

incurred for the purpose of long term advantage

Capital Expenditure

Definition:

Expenditure incurred in purchasing or

constructing property which is intended to assist

in the production of profit or in permanently

improving, enlarging or extending existing

property in order to increase its profit earning

capacity. The direct benefit of such an

expenditure will extend over several trading

periods and it replaces cash by permanent asset.

(Rowland, S.M. in Principles of Accounting)

Guidelines to determine that expenditure is

capital expenditure:

1. Increases Profits

• If expenditure is for the purpose of increasing profit

either positively by increasing earning capacity or

negatively by decreasing working expenditure (day to

day expenses)

2. Produces an asset

• If whether increasing the earning capacity or not, it

produces an asset comparatively permanent in nature.

Examples of Capital Expenditure

1. Purchase of permanent tangible asset

– such as plant and machinery, office equipment, furniture

2. All sums spent up to the point an asset is ready for use

– including expenditure on its purchase, receipt or erection

• eg. cartage charges paid to bring the machinery to factory,

• installation charges,

• fees paid to lawyer for drawing land purchase deed,

• overhauling expenses of second-hand machinery,

Examples of Capital Expenditure

3. Financing cost for a fixed asset

• (i.e. interest paid on loans to purchase a fixed asset) for the

period up to the time the asset is put to use. Such interest is

added to the cost of fixed asset.

4. The amount spent on existing asset for the purpose of

its improvement or extension

• which will raise the output or reduce the cost of production

5. Money paid for goodwill

6. Money spent to reduce working expenses

• eg. Conversion of hand-driven machinery to power-driven

machinery.

Revenue Expenditure

• It is an expenditure on consumable items, on

services and on goods acquired for resale.

These are expenses whose benefit expires within

the year of expenditure and which are incurred to

maintain the earning capacity of existing assets.

Revenue Expenditure

Revenue items generally include:

• The cost of materials used in manufacturing goods

intended for resale.

• Wages paid in connection with the production of goods

meant for sale.

• Selling and distribution expenses.

• All expenses incidental to the working of the business

such as depreciation, rent, salaries, interest, etc.

• All expenses incurred for maintaining the efficiency of

fixed assets by means of repairs, replacement, renewals

and insurance.

Principles for determining the nature of

expenditure 1. Expenditure in the

– acquisition of an income earning asset - capital expenditure

– in the process of earning of the profits - revenue expenditure.

2. Expenditure made for the initiation or extension of a business or for a substantial replacement of equipment - deemed to be capital

3. Expenditure made not only once and for all but brings into existence an asset or an long term advantage - capital expenditure

4. Whether the expenditure incurred was part of the fixed capital of the business or part of its circulating capital

Distinction between Capital and Revenue Expenditure

Capital Expenditure Revenue Expenditure

Incurred in acquiring or

improving permanent assets not

meant for resale. May add to value

of an existing asset

Is a routine expenditure incurred

in the normal course of business

and includes cost of sales and

maintenance of fixed assets.

Increases earning capacity Maintains the earning capacity

It is normally a non-recurring

outlay.

It is usually a recurring item

It produces benefit over several

years.

Thus a small part is charged to

income statement as depreciation

and the rest appears in the

balance sheet

It is consumed within an

accounting year i.e. benefits

only one year.

Thus entire amount is charged to

income statement.Does not

appear in the balance sheet.

Is an item of balance sheet Shown in Trading and profit &

loss A/c

1. Wages: wages on erection of plant & machinery or construction

2. Raw material and stores used in construction of fixed asset

3. Transport charges: incurred for new plant & machinery

4. Interest on capital: Interest on capital especially where the nature of

business requires construction work for a long period, before the

commencement of the production.

5. Legal expenses: Legal expenses incurred to acquire the assets

6. Repairs: Repairs on purchases of second-hand asset to put into

workable condition

Certain revenue expenditures are treated as capital expenditures since

they lead to the establishment of business and its efficient running in the

following circumstances:

Revenue Expenditure becoming Capital Expenditure

Deferred Revenue Expenditure

For Example: Heavy advertising expenditure incurred in

introducing a new line or developing a new market, Cost of

issuing shares and debentures, Cost of experiments, discount on

debentures, Preliminary expenses

Deferred revenue expenditures are expenditures which

are basically in the nature of revenue expenditure but

whose benefit covers a number of years i.e. their benefit

may extend over a number of years.

Distinction between Capital Expenditure

and Deferred Revenue Expenditure

1. Nature of expenditure -deferred revenue expenditure is a

revenue in nature but it is incurred for > one accounting yr

2. Years of benefit: The deferred revenue expenditure

benefits lesser number of years in comparison to capital

expenditure.

– Deferred revenue expenditure-for 3-5 years

– Capital expenditure-for 10-15 years

3. Recovery:

– Deferred revenue expenditure - once incurred cannot be

recovered back generally

– Capital expenditure - capable of being reconverted into cash

though at a loss